to work well without any clear-cut theoretical justification

CDS are not, however, the only synthetic financial instruments that have proved toxic. The same applies to the slicing and dicing of collateralised debt obligations and to the portfolio insurance contracts that caused the stock market crash of 1987, to mention only two that have done a lot of damage. The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments? The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.
Now that the bankruptcy of Lehman has had the same shock effect on the behaviour of consumers and businesses as the bank failures of the 1930s, the problems facing the administration of President Barack Obama are even greater than those that confronted Franklin D. Roosevelt. Total credit outstanding was 160 per cent of gross domestic product in 1929 and rose to 260 per cent in 1932; we entered the crash of 2008 at 365 per cent and the ratio is bound to rise to 500 per cent. This is without taking into account the pervasive use of derivatives, which was absent in the 1930s but immensely complicates the current situation. On the positive side, we have the experience of the 1930s and the prescriptions of John Maynard Keynes to draw on.
The bursting of bubbles causes credit contraction, the forced liquidation of assets, deflation and wealth destruction that may reach catastrophic proportions. In a deflationary environment, the weight of accumulated debt can sink the banking system and push the economy into depression. That is what needs to be prevented at all costs.
It can be done n by creating money to offset the contraction of credit, recapitalising the banking system and writing off or down the accumulated debt in an orderly manner. They require radical and unorthodox policy measures. For best results, the three processes should be combined.
If these measures were successful and credit started to expand, deflationary pressures would be replaced by the spectre of inflation and the authorities would have to drain the excess money supply from the economy almost as fast as they had pumped it in. There is no way to escape from a far-from- equilibrium situation n global deflation and depression n except by first inducing its opposite and then reducing it.
To prevent the US economy from sliding into a depression, Mr Obama must implement a radical and comprehensive set of policies. Alongside the well- advanced fiscal stimulus package, these should include a system-wide and compulsory recapitalisation of the banking system and a thorough overhaul of the mortgage system n reducing the cost of mortgages and foreclosures.
Energy policy could also play an important role in counteracting both depression and deflation. The American consumer can no longer act as the motor of the global economy. Alternative energy and developments that produce energy savings could serve as a new motor, but only if the price of conventional fuels is kept high enough to justify investing in those activities. That would involve putting a floor under the price of fossil fuels by imposing a price on carbon emissions and import duties on oil to keep the domestic price above, say, $70 per barrel.
Finally, the intern...